Fox News wins the Hype Award for the Argentina debt story

It is sad to see Fox News publish a horribly written story called "Litigious investors ask US Supreme Court to deny Argentina a 'do-over' on $1.4B debt ruling" from the Associated Press (here). First of all in the US taking someone who defaulted on debt to court is not "litigious", it is standard practice. Americans are generally quite proud of that right. But this clearly pro-Argentina story continues with more nonsense.

Fox News: - The "Aurelius Respondents," another group of hedge funds and holding companies based in the Cayman Islands and the U.S. state of Delaware to avoid taxes and scrutiny, urged the justices to deny Argentina's "do-over" request, saying "a chorus of disinterested parties has recognized that Argentina is without peer in its mistreatment of private-sector creditors."

Just to be clear, the Cayman entities are in the Cayman Islands because they are either owned by foreign organizations who are not supposed to pay US taxes (such as Canadian pensions) or by US corporate pensions who are tax exempt. As far as Delaware, those owners will certainly pay their share of taxes because these are pass-through entities. Fox News - check out something called Schedule K-1. And with respect to avoiding "scrutiny", the managers of these entities are Registered Investment Advisors regulated by the SEC. And for those who have been through an SEC RIA audit know there is no shortage of scutiny there.

Argentina is mocking the US legal system by appealing the court decisions in this case and then saying it won't comply with any final court ruling if it is not in Argentina's favor. Of all the news agencies it is particularly surprising that Fox News did not check the facts on this and is in effect buying Cristina Fernandez's propaganda on the issue. Congratulations on winning the Sober Look Hype Award.

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From our sponsor:

The unprecedented chase for yield

The major market surprise of 2014 so far has been the extent of investors' appetite for yield in the developed fixed income markets. It has been quite spectacular. The Eurozone in particular has been a key beneficiary of this trend. We've seen German government bond yields hit a low not seen in almost a year (see Twitter post), but the real action has taken place in the periphery bonds. We are seeing multi-year and even all-time lows in government bond yields.

Source: Investing.com

And this trend is not limited to sovereign paper. European corporate high yield bonds are now yielding  just over 3.6% on average - a record low. Let's just put this in perspective - this is sub-investment-grade paper trading at these levels.

While European fixed income markets clearly feel frothy, it is not clear if there is a near-term catalyst to bring about a correction. With the Eurozone inflation still MIA, capital seems to be chasing anything with a reasonable yield. The shift in attitudes from just two years ago is unprecedented.

Bloomberg: - “We’re still in a world where investors are starved of return,” said John Wraith, a fixed-income strategist at Bank of America Corp. in London. “People are still happy to diversify their holdings and buy bonds that not so long ago they would have shied away from. The slightly better data helps reassure people that finally some of these weaker countries are turning a corner.”

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European Commission's irrational fear of sovereign CDS markets is politically motivated

The European Commission (European Securities and Markets Authority) continues to press their heavy handed CDS regulations in spite of the objections by the UK and Germany. These two states are particularly annoyed at the EC rules that require a CDS protection buyer to be able to prove that they are engaged in hedging a specific asset (or assets) - prohibiting the so-called "naked CDS". That means one can not buy protection on France for example as a general hedge against a downturn in European sovereign finances or the economy as a whole (see discussion). This is the equivalent of prohibiting investors from buying put options without owning the equivalent number of shares in the underlying stock.

UK/Germany: - We regret especially that the hedging requirements concerning CDS are very narrow and inflexible. This could e.g. hinder investments in member states with illiquid CDS markets significantly and hedging against general economic risks.

So let's take a look at the reasons the EC is so scared of CDS. The explanation we keep hearing is that buying CDS protection can be used to "attack" a sovereign debt market. The evil speculators will use CDS to bring down nations by artificially raising sovereign yields. That is absolute and utter nonsense. All the EC has to do is take a look at the data. The chart below compares gross and net Spanish sovereign CDS notionals with Spanish government debt outstanding.

Source: Fitch

First a few words about the gross CDS number. The gross represents nothing more than the trading volume (with a lag). Here is an example:

ABC Fund
1. buys 10MM protection on Spain from DB
2. sells 5MM protection on Spain to JPMorgan
3. sells 5MM protection on Spain to SocGen

ABC Fund now has zero net Spain CDS exposure and 20MM gross Spain CDS exposure. The more ABC Fund trades, the larger the gross will be because the fund is required to get the best pricing for its investors by using multiple counterparties. That is why as Spain got deeper into trouble and trading volumes increased, the gross grew. In spite of that increase, the gross number is still a fraction of Spain's total debt outstanding. Moreover with the clearinghouse coming online, ABC Fund will be able to net all three positions and the gross notional will collapse.

But in order to influence sovereign bond yields, one needs to put on large net positions - gross notional has no impact on spread/yield. And net CDS positions are barely visible on the chart above (in red circle). A similar relationship between debt outstanding and net CDS notional can be found for Italy (chart below). Claiming that such tiny exposures can somehow threaten the sovereign bond markets is absurd.

Source: Fitch

What is really happening however is that the CDS markets often act as a "canary in a coal mine", pointing to a specific credit weakness. CDS spreads provide transparency, particularly when transparency is not readily available from other less liquid markets. And many EU politicians and bureaucrats hate transparency because it puts their governments' poor practices on display. So they blame the CDS markets for "attacking" their nation. Everything was fine with Greece until those evil CDS speculators showed up.

SoberLook.com

Spanish spreads hit new records as larger bank bailout expectations grow

As expectations of ever larger bank bailouts in Spain hit the market, both the 5-year and the 10-year Spanish government spread to Germany reached new records, with the 5-year spread exceeding the November high for the first time.

5yr Spain sovereign spread to Germany

10yr Spain sovereign spread to Germany

Boston.com: - The board of Bankia, the large Spanish bank that was taken over by the government, met Friday to discuss a restructuring plan that will include a request for more state aid, bolstering calls for a coordinated relief blueprint for Europe’s fragile financial sector.

Trading in shares of Bankia, the country’s fourth-largest lender, were suspended Friday while its board determined how much new aid it needs. The bank’s shares have whipped about violently in recent weeks on fears it could succumb to the massive losses it has built up in the country’s collapsed real estate sector.

The bailouts were never built into the debt to GDP ratio projections. The debt levels have strayed from the target even before the additional support for the banking system became necessary. Nobody really believes that Bankia is an isolated case, raising the possibility that Spain would need to undertake an Ireland-style banking recapitalization. That may require external support from EFSF/IMF, which frightens existing bond holders as they continue to sell Spanish debt.

SoberLook.com

The bank-sovereign linkage in the Eurozone

The periphery banks are now inextricably tied to the path of their nation's sovereign debt. One of the things that made the Greek bond restructuring so difficult was the fact that the Greek sovereign bond write-down instantly made Greek banks insolvent. Greece had to use €50 billion of the EU financing just to recap the banking system. This issue has become acute in other Eurozone nations.

Take Italy for example. Sovereign spreads have been highly correlated to the valuations of Italy's financial firms.

MSCI Italy Financials Index vs 10y Italy sovereign spreads

 The amounts of Italian government debt these firms have been purchasing is quite staggering.

Source: Barclays Capital

If you look at the largest Italian banks, the amount of sovereign debt they now hold represents a significant part of their balance sheets. Unicredit, the largest Italian bank that is relatively well capitalized, holds its core capital equivalent in sovereign bonds. Banca Monte dei Paschi di Siena holds three times the capital.

Source: Barclays Capital

This process effectively ties banks and the government into a cycle of maintaining each other's solvency, creating a fairly nasty feedback loop. The challenge for the Eurozone periphery in the long run will be trying to unravel this linkage. Otherwise the "real economy" does not stand a chance of resuming growth.

Source: Euro-nomics group

SoberLook.com

Spain's spreads breaking away from other risk indicators

As the sell-off in Spanish government bonds continued today, Spain's spreads broke away from other global macro risk indicators. Typically Spain's bond and CDS spreads move in tandem with risk measures such as VIX or SovX WE (MarkIT Western European index of sovereign CDS), etc. But this time around, the widening has outpaced these other measures. As an example consider the relationship between Spain's 10yr bond spread (to Germany) and SovX WE (chart below). The red asterisk indicates the current levels.

Spain to Germany 10y Gov. spread vs. SovX WE spread (last 2 years; source: Bloomberg)

One can run the same comparison against VIX or swap spreads and get a similar result. Using Spain's CDS spreads rather than bond spreads also shows that we are in an uncharted territory with respect to this widening. Consider for example that the last time Spain's 10-year spread was at current levels (4.3%), VIX was around 30 (it's 21 today) and the USD 2-year swap spread was over 50bp (31bp today) - see chart below.

Spain to Germany 10y Gov. spread vs. USD 2 year swap spread

Clearly there is plenty of room for the other risk indicators to "catch up" with Spain. But for now it stands on its own with respect to the relative amount of risk that is being priced in. More Spanish and Italian debt auctions loom and it is uncertain just how much more room the periphery banks still have to absorb the extra debt. In the mean time foreigners continue to sell.

Reuters: Spain has found itself the focal point of those concerns after relaxing budget targets earlier this year and with subsequent budget-cutting plans winning little investor support - culminating in weak demand at an auction last week.

Spanish 10-year yields jumped 22 bps on the day to a four-month high of 5.99 percent before finding resistance at the psychological 6 percent barrier - though few in the market believed that level would halt the selling.

"We're going to see Spain develop as the story this week as hedge funds look to short it," a London-based trader at an investment bank said.

SoberLook.com

The escalation of Spain's regional debt

As the Spanish government spreads grind higher, it is becoming increasingly clear that Spain will have a difficult time reaching its target of 5.3% debt to GDP this year and particularly the 3% targeted for next year. Goldman's latest report is forecasting this year's number to be 6.8% and next year to be double the target of 6%. Achieving targeted fiscal consolidation will be nearly impossible, at least in the near term.

Recent movements in 5yr  Spain-Germany spread (Bloomberg)

But a more dangerous development in Spain's fiscal conditions is the increasing leverage of regional governments, which account for close to half of public spending in Spain. As the central government tries to reign in spending, the local governments attempt to pick up the slack. Regional government debt as a percentage of regional GDP has spiked materially in the last few years.

Source: GS

And the situation seems to be getting far worse with current regional budget balances all in the red.

Source: GS

Spain's central government is trying to pressure regional governments to contribute to the overall debt reduction. But the regions' local politicians are often not incentivized to comply. The tension between the regional and the national governments have been escalating.

Reuters: ... following Sunday's regional election result, which denied Rajoy the absolute majority he had hoped would reinforce his mandate for spending cuts, the prime minister will have to measure his next steps to avoid sparking more protests.

The Law for Budget Stability which is going into effect later this year should help apply pressure on the regional governments to control spending increases. But ultimately it looks as though the central government will need to bail out a number regional governments just to allow them to pay their bills. That is not expected to be constructive for Spain's overall fiscal consolidation.

Reuters: Police presence was particularly heavy around parliament where lawmakers were due to debate measures to help heavily indebted local and regional governments pay money owed to suppliers.

For further developments on the regional debt problem, see this BBC video. 

SoberLook.com

The new Greek yield curve

The Greek PSI (new) bonds are now actively quoted. Prices vary with maturities - roughly between €17 and €25 (17 to 25 cents on the euro). Here are the latest mid quotes by maturity.

Latest quotes on Greek PSI bonds

Using Bloomberg these can be converted to yield, producing the following yield curve. This is a unique sovereign curve even for a distressed name because it starts in 2024, with nothing actively quoted prior to that.

The new (post-PSI) Greek yield curve (Y-axis = yield in %)

It is naturally an inverted curve that is pricing in a significant probability of a second default. Depending on the recovery assumptions, the probability of default priced into these bonds in the next 10 years is near certain (the higher the recovery assumption, the higher the implied default probability). Being subordinated to the EU/IMF rescue loans, these bonds don't stand to recover much the next time around.

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Migration of sovereign debt from private hands to public institutions

The percentage of Greek debt held by public institutions as opposed to private investors has grown dramatically in recent years. In some ways this is similar to the US after 2008, with various Fed/Treasury programs, including Maiden Lane and the GSEs. Sadly, Greece will end up with the same or higher debt to GDP ratio than they had before the restructuring (IMF estimate is 167% for 2013 - for more information on the topic see this post from Kostas Kalevras.) In part this is due to Greece spending some €50 billion to bail out their own banks who are now bankrupt after having participated in the PSI (Greek banks held a big portion of Greek government debt and took a massive hit to their capital).

But this process of shifting an ever larger proportion of sovereign debt onto the public balance sheets is not unique to Greece. Even without the PSI, Portugal is also in that camp.

GS Research: ... As shown in chart below, Portugal is on a similar path. On the basis of the existing troika package (and again making assumptions about the SMP holdings), around 60% of Portugal’s sovereign debt will be held by the official sector by the end of next year. Should Portugal be unable to re-access the market in September 2013 (an eventuality that can certainly not be ruled out), that figure rises further – even in the absence of a Portuguese PSI.

Just as Greece, Portugal has been bailing out its banks, but quietly. Portugal basically had the nation's large banks issue unsecured debt to themselves. The Portuguese government would slap a guarantee on that "internally issued" debt. The banks would then use their own bonds as collateral at the ECB to get LTRO financing. As an example on December 5th, BCP, a large Portugese bank issued €1.35B bond to itself with the government guarantee and placed it with the ECB as collateral (hat tip Alex Goncalves, @alexdgn). For more information on these activities see this story (in Portuguese). Excluding half of their State-owned enterprise (SOE) debt and bank bond guarantees from their debt to GDP ratio may in fact put them in a materially worse position than the troika's assumptions and requirements.

Bloomberg: A similar [to Greece] shift of risk to taxpayers is happening with Portugal and Ireland. The ECB has bought 20 billion euros of each nation’s debt [this excludes lending to banks], according to Open Europe estimates, while the EU and the IMF provided 78 billion euros and 85 billion euros, respectively, in new loans to replace private financing for the two countries.

In Ireland, most of the public money has been used to pay the debt of failed Irish banks. The ECB and the Irish central bank have taken over financing of the lenders, providing about 140 billion euros of funding and transferring risk to taxpayers.

Since the November 2010 bailout of Ireland, European lenders have reduced their exposure to that country’s banking system by more than half to 61 billion euros. While current and past Irish governments have tried to stop paying banks’ debts with public funds, the EU has rejected the requests.

This migration from private hands to public institutions does not include the enormous amounts lent by the ECB to the banking system, which for many European nations is a proxy of their governments (such as in the case of Portugal's government guaranteed bank bonds). The hope is that this shift will provide enough time and flexibility for these nations to eventually tap the private markets again. But given these GDP trends and the "cheating" that's going on with respect to these debt to GDP ratios, the public institutions (and therefore the Eurozone taxpayer) will have to wait a long time and take losses along the way before this becomes a reality.

SoberLook.com

Italian bureaucrats learned Rate Swaps 101 at Harvard

Here we go again. Confusion reigns supreme about Italy's so called "derivatives bets" on which Morgan Stanley collected some 2.6 billion euros. Lets look at some media quotes.

Reuters: Education Undersecretary Marco Rossi Doria made the announcement in answer to a parliamentary question after U.S. investment bank Morgan Stanley said it had received 3.4 billion euros to close derivatives contracts with Italy's Treasury.

The Italian government has made the same error that Harvard University made some years back. See the post called Harvard's big swap unwind from 2009. Italy, with its numerous municipal capital projects had always been concerned about rising interest rates. If rates were to go up they reasoned, their financing costs will go up as well. So as the Euribor rates came down some time ago, they figured they would lock in what they thought at the time were attractive financing rates. The government put on swaps and some swaptions that would rise in value if the long term swap rates were to rise (to compensate them for rising funding costs). But swap rates kept falling in 2011 as the Eurozone was looking into the abyss.

10yr EUR swap rate (Bloomberg)

Unfortunately for Italy, their funding rates completely decoupled from swap rates. Swap rates represent the forward expectation of Euribor (for the next say 10 years). These rates were elevated relative to German bunds, but were still declining as German rates kept falling. So not only was Italy losing money on the swaps because of lower swap rates, but the nation was also having to pay much more for funding because its sovereign credit risk increased. This is an example of "basis risk", when your hedge decouples from what you are hedging and both end up going against you.

To add insult to injury, Italy also got downgraded to a level that triggered the swap/swaption unwind.

Reuters: He said the contracts with Morgan Stanley, made up of two interest rate swaps and two swap options, were closed under an "Additional Termination Event" clause.

These co-called break clauses are rare in contracts involving sovereigns, and the clause was only present in the Treasury's contracts with Morgan Stanley, Rossi Doria said.

"Additional Termination Event" clauses are common under ISDA agreements. Some of these clauses basically state that if one counterparty's credit deteriorates, the derivatives contracts in place between the two counterparties terminate. So Morgan Stanley terminated the contracts with Italy based on the downgrades and received the unwind value.

Of course the media hype out there makes it sound as though Morgan Stanley suddenly made 2.6 billion euros. It didn't. Its swaps were hedged - so whatever it made on Italy, it lost on the hedge and other offsetting trades (except for the initial spread).

The media confusion gets even more strange when they try to reconcile the numbers between what Morgan Stanley reported on its books and what Italy actually paid them.

Reuters: He did not account for the discrepancy between the 2.567 billion euros he said the Treasury had paid to Morgan Stanley and the 3.4 billion euros referred to by the bank in its report to the U.S. Securities and Exchange Commission.

There is nothing to "account for". Not all the contracts with Italy have been unwound and Morgan Stanley was showing its mark to market (unrealized) gains. So Italy is taking more pain than the 2.567 billion euros they paid out - the remaining losses just haven't been realized. It's unclear if Morgan Stanley has or can call for margin as was the case with Harvard.

The more troubling point is the size of Italy's swaps still outstanding.

Reuters: He added that the state still has derivatives contracts worth some 160 billion euros, or nearly 10 percent of the 1.624 trillion euros of Italian bonds in circulation.

Because these are off balance sheet, it is unlikely that they are reflected in Italian government's overall liability measure. But even if these swaps are under water by say 10% (very roughly, 100bp move in swap rates times duration of 10), it will add another 1% to Italy's outstanding debt. 16 billion - extremely painful, but not the end of the world for Italy.

The media confusion continues (don't mean to pick on Reuters - other outfits like Bloomberg are just as confused):

Reuters: Italy's use of derivatives to guarantee its public debt yielded a loss of 2 billion euros in 2011 in the form of higher interest payments and 4 billion euros in 2007-2010, official figures show.

Guarantee? There is no guarantee here. The reporter here must be confusing rate swaps with CDS - two slightly different contracts. These are just interest rate hedges gone terribly wrong. Apparently the Italian bureaucrats responsible for these hedging programs went to Harvard to learn how it's done.

SoberLook.com

The ECB is making banks an offer they can't refuse: buy sovereign paper

If you are the ECB and you are not legally permitted to purchase outright material amounts of eurozone bonds (at least not now), what options do you have left to stabilize the eurozone? One option that has been kicked around is you would lend to the IMF, who in turn would buy the bonds. But that's tricky to implement and would run into all sorts of opposition.

An alternative is to have the eurozone banks load up on more sovereign debt, but the trick is to incentivize them to do so. What ultimately brought down MF Global when they held sovereign bonds was a funding squeeze. They held these bonds via a short-term repo and the counterparties refused to roll the repo loans.

Keenly aware of this issue, the ECB is making banks an offer the can't refuse - term funding via 3-year loans at 1%.

ECB Benchmark Rate

Now the banks don't have to worry about financing by purchasing bonds with maturities under 3 years and locking in the spread. Of course the worry is still default risk. But it is fairly certain that Spain for example is not going to default in the next six months. At 3-4% the Spanish 6-month bills now look attractive as the banks would be locking in 200 - 300bp with no capital usage (the 1-3-5 rule: borrow at 1% lend at 3% and be on the golf course by 5.) In fact the bills could be used to satisfy the banks' liquidity ratio requirements as well.

So the only risk remains is a significant downgrade of Spain within the next six months, making Spanish debt ineligible as collateral at the ECB.  The AA- can and probably will drop at least a notch.  But no worries - should  Spanish debt get downgraded to junk, the ECB will simply waive the rating requirement as it did with Portugal.

In response, the Spanish six-month bill yield is down 300bp from the peak. 

Spanish 6-month bills yield (Bloomberg)

This solves two problems for the ECB:
1. It gets banks to buy material amounts of eurozone sovereign debt where the ECB is unable to do so.
2. It also slowly recapitalizes the eurozone banks by giving them an opportunity to make significant amounts of money over time without much capital usage.

See updates under "Comments"

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Sovereign debt and the Basle rules - clearing up the confusion

There seems to be some confusion around the Basle banking regulation with respect to sovereign debt.  We want to take a quick look at two distinct concepts here: "risk weights" used to determine capital ratios and "liquidity ratio" used to make sure banks have sufficient short-term liquidity.

1. First let's take a quick look at risk weights for sovereign holdings. The matrix below outlines what the risk weights currently are for sovereigns, financials, and corporates based on what's called the "standard model" for risk weights. Some institutions apply "internal ratings" using models that have been approved by their national bank supervisor, but for discussion purposes, let's focus on the standard model.

The rule of thumb is that you take the "risk weight" shown above and multiply it by 8% (assuming you want at least an 8% capital ratio) to determine how much capital you need against this asset (that is how much leverage is allowed). The problem with European banks is that it was easy for them to accumulate a great deal of sovereign debt because in most cases there was no capital charge at all.

The lower rated paper would require 2%-4% capital vs. an equivalent rating corporate loan for example that would require the full 8%. That is why there is so much focus on sovereign downgrades as lowered ratings automatically increase risk assets of these banks without them even buying anything. And as paper moves into "junk" category the capital requirement increases could be quite sharp. Therefore Basle-III may adjust this matrix to make sure there is always some capital held against sovereign debt.  The transition process however will be painful.

2. Then there is the issue with sovereign debt for LCR (Liquidity Coverage Ratio), which is a separate Basle-III requirement. Below is a quick definition of the ratios from Risk:

The liquidity measures are split into two: the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The former is designed to ensure banks have enough high-quality, liquid assets to survive a 30-day period of acute stress, while the NSFR is meant to eliminate funding mismatches by establishing a minimum acceptable amount of stable funding based on the liquidity characteristics of a firm’s assets and activities over a one-year horizon. This latter ratio is some distance away from being ready for implementation, some market participants claim.

LCR is already regulated and measured, but the full requirement isn't going into effect until 2015. To maintain sufficient short-term liquidity, banks would be required to hold a certain amount of "liquid" assets.

Businessweek: Basel’s so-called liquidity coverage ratio, scheduled to be phased in starting in 2015, requires banks to hold enough “high-quality liquid assets” -- predominantly cash and government debt -- to survive 30 days of stress. Only a quarter of 28 of Europe’s largest banks would comply today, leaving a shortfall of 500 billion euros ($670 billion), according to a Nov. 29 report by Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

Typically those assets would be sovereign bonds, but recently there has been talk about permitting liquid stocks and corporate bonds to be applied to this ratio as well.  This is not a new issue:

CentralBanking.com (15 Jun 2011):  The French prudential regulator, Autorité de Contrôle Prudentiel (ACP), appears to be at odds with the Basel Committee on Banking Supervision over whether equity should be included in the liquidity coverage ratio (LCR). In an interview with Risk, Danièle Nouy, secretary-general of the ACP, expresses concern that the list of eligible assets under the LCR is too narrow and should be broadened. The LCR, finalised by the Basel Committee last December, requires banks to hold enough liquid assets to survive a 30-day period of acute stress – and stipulates that a majority of the buffer should comprise cash and government bonds.

This is certainly going to generate debate.  Ultimately both the capital ratio and the liquidity ratio frameworks will have an impact on sovereign debt quality and volumes held and traded by financial institutions.

SoberLook.com

All is well with the world - particularly in Europe

All is well with the world again. Italy sold €8 billion of new paper and the fact that there were buyers even at record yields pushed up the equity markets. French and Spanish bonds rallied in sympathy.

But at some point the world will remember that Italy has €33 billion of debt coming due in the final week of January and another €48 billion in February.

As US equity futures rally, the ECB continues to provide increased amounts of secured financing to European banks in a fashion similar to the Fed's TAF operations.

Bloomberg ECBATOT - Variable Rate Repo Auction Allotment.

These institutions then promptly convert some of those borrowed euros to dollars in order to fund their dollar assets, driving up demand for currency basis swaps. The spread on the 3-month EUR/USD basis swap has promptly crossed the psychologically important level of -150.

3-month EUR/USD basis swap (Bloomberg)

So all is well with the world as the equity markets continue to rally.

SoberLook.com

Germany's rude awakening

Germany is in for a rude awakening as investors come to the conclusion that the nation will have no choice but to support troubled European nations. It can do it in two ways - either through massive euro devaluation (via QE) or by increasing it's own debt burden (as it did with East Germany integration). This does not help German government debt. The eurozone crisis is starting to take it's toll as investors are abandoning all eurozone bonds, Germany included. The German 10-year yields have now gone above those of the UK and significantly over the US Treasury note.

Bloomberg

This is a dangerous development because it creates a confidence problem that quickly spreads to global financial institutions who have been trying to reduce their exposure to "fringe" European states and roll into the "safe" German paper.

How does that impact the US?  Below is a regression plot of EUR/USD against the S&P500 since October-2011. The correlation is now above 0.85 - the Euro might as well be as US stock.  And this correlation increase is not unique to the US equity markets. No market is safe.

Bloomberg

Eurozone Interbank Stress

The stress in Europe's interbank system is continuing to build. EUR swap spreads are hitting new recent highs this morning, approaching the highs of 2008. The market is anticipating prolonged elevated premiums for term funding.

EUR 2-Year Swap Spread (Bloomberg) 

With Spanish bond spreads over Bunds hitting new highs, the banking system that holds a great deal of sovereign paper is feeling the pressure.

Spain 5-year vs. Germany 5-year (Bloomberg)

Deutsche Bank 5-year CDS hit 240bp, near the recent highs. If you tried to tune out this weekend, welcome back to reality. Happy Monday.

SoberLook.com

Goodnight Vienna?

With the Europe's market madness continuing, everyone is focused on Italy and Spain. But the "flight to quality" doesn't stop there. Here is a quick look at the Austrian 5-year bond spread to Bunds (Bloomberg).

Austrian financial institutions have relatively little exposure to "fringe" Western Europe. Instead the bond market seems to be uneasy about the Eastern Europe exposure.

WSJ: Today, it’s the euro zone that has started a wave of risk aversion that is only now engulfing the weaker Eastern European states. The first to suffer has been Hungary, where the forint plumbed a new record low against the euro Tuesday on concerns about a possible downgrade from one or more of the leading rating agencies, and despite better-than-expected annual growth of 1.4% in the third quarter.

This in turn started a round of rumors (which seem to be rampant these days) about a downgrade of Austrian sovereign bonds and the spread spiked.

 Vienna

SoberLook.com

Europe's Unsustainable Markets

The situation in Europe feels unsustainable. The volatility comes and goes in waves, and each consecutive wave is worse than the previous. This morning Spain had a fairly bad bill auction (felt like Spanish banks ended up buying most of the paper) and European government bonds started unraveling. Spanish and Belgian bond spreads (to Bunds) hit new records. The most troubling is the selloff in French bonds. This is no longer the "fringe" of Europe, but the core. Below is the spread for 5-year French bonds - a new record.

Source: Bloomberg 

Simultaneously the interbank lending indicators continue to show stress. Below is a chart of the 2-year EUR Swap Spreads. We are now at levels not seen since late 2008.

Source: Bloomberg 

As scary as Europe looks, the US may be following a different path. More on that later on.

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